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ECON 1110 Lecture Notes 08

ECON 1110 Lecture Notes 08 - ECON 1110 Lecture Notes 8 ECON...

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ECON 1110 Lecture Notes 8 ECON 1110 Intermediate Macroeconomics James R. Maloy Spring 2011 Lecture Notes for Topic 8: Keynesian Macroeconomics (IV) Readings: Froyen Chapter 8 (8 th Ed. Ch. 9) I. The Keynesian View of Prices We have seen that the intersection of IS and LM give the level of aggregate demand, but until this point we have assumed that the price level was fixed, and that whatever quantity was demanded could be provided at that given price level. At the time of Keynes' General Theory (1936) it was not an unacceptable argument—during the Great Depression output was so low and resources so underutilised that any increase in demand could probably be met without triggering inflation, which is often the result of high demand putting pressure on scarce resources (demand-pull inflation). Keynes had several rationales to explain sticky prices. One was the idea of menu costs . There are administrative costs associated with a change in prices, such as changing signs and printing new menus. These can discourage sellers from rapidly changing prices. Another explanation could be customer relationships . For example, in 1995 France raised VAT (value added tax; i.e. sales tax) by 2%. However, to attract customers and maintain a good relationship with existing customers, many stores chose to absorb the increase and still sell for the same VAT-inclusive price. Furthermore, contracts can bind a company into selling something for a certain price for a certain time frame, thus making prices rigid. However, anyone can see from everyday life that the assumption of completely fixed prices in generally unreasonable in normal times. An increase in demand under a full employment situation will put more pressure on scarce resources (including workers), and will therefore drive up price levels. In order to get a better picture of an economy with variable prices, we need to derive Keynesian aggregate demand and aggregate supply curves, which will demonstrate the relationship between output and prices. 1
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ECON 1110 Lecture Notes 8 II. The Keynesian Aggregate Demand Curve We have spent considerable time in previous weeks discussing the factors that determine aggregate demand in the Keynesian system. These factors are, namely, the ones that determine the IS and LM curves and the interest rate and income level at which the money market and goods market are simultaneously in equilibrium. Since the intersection of IS and LM gives the level of AD (which we , in order to derive the aggregate demand curve, it is necessary to see how a change in prices will affect the real variables in the IS-LM model. The IS curve is given by: I ( r ) + G = S ( Y ) + T Government spending and taxes are set by the government in real terms, and a change in the price level will not affect their real values. Investment is given in real terms—the real level of investment depends on the interest rate, so for any given interest rate real investment will be the same. Likewise, real savings depends on real income, and the level of real savings is therefore not directly dependent on the price level.
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